Outperformance is not the point

The point of investing is sleeping at night

The end object of investment ought to be serenity.

George J.W. Goodman

I’ve been a bit critical of indexing strategies, and so you may be surprised to hear that I don’t also believe that active management can reliably outperform passive strategies.

The HNW Industrial Complex loves using allocators to build portfolios for wealthy investors. And allocators build portfolios based on the idea of selecting active managers with various specialties. These consultants will introduce you to “the best” small-cap, large-cap, global, US, or emerging market equity managers. And in all my years of working with these consultants, through direct experience as a client and also through working with estates, foundations, and pension committees, I have found that they are full of shit. I haven’t seen any reliable indication that any consultant can identify outperforming managers. And research backs that claim up.

And lest you think I’m being unfair, I’ll include myself in the mix. I did my time as an allocator, and while I had some success selecting managers, it didn’t come from reviewing charts and tables, which is the method preferred by the consulting industry. Rather, it came from meeting with the managers and their teams, hearing their stories and gauging the passion they had for investing. I did find some exceptional managers, but my sample size isn’t large enough to attribute it to anything other than luck. I say this not to be modest, but because I know that I also found managers who said all the right things, conferred the appropriate level of confidence, and yet still failed to keep up with their passive benchmarks over large stretches of time. One hedge fund manager I was particularly enthusiastic about (and who, thankfully, my clients did not end up allocating capital to) ended up closing his fund within two years of our initial meeting.

So when the academic finance brigade tells us that we can’t reliably select the managers who will outperform in the future, I agree with them wholeheartedly.

But that’s not the point.

The point is conviction.

It’s easy to ride an index up during a bull market, but much harder when the trend is headed down.

Passive investing strategies may leave me uncertain about what I really own, or what risks I’m actually exposed to.

Academic factor-based strategies may be out of favour for decades, and most people lose faith in them at the exact moment they are about to come back into fashion.

The home-run mentality in VC and the ultra-diversified “endowment model” approaches end up disappointing more often than not, and the lack of liquidity can leave you trapped in an investment for years.

I know from experience that all of these strategies can shake my conviction. I don’t believe in them, and I tend not to stick with them when the going gets rough.

The only strategy that I have seen that reliably works over time, in all markets, is the strategy of buying excellent companies and holding forever. That’s a strategy that I have conviction in.

Hopefully, outperformance will be a byproduct of that conviction, but there’s no guarantee. What should be guaranteed, though, is that I’ll be far less likely to bail on the strategy when the world looks like it’s about to end (which seems to happen once every decade or so). I’ll be able to sleep at night. I might even be willing to add more to the portfolio while the rest of the world panics and sells.

That’s how active management can shape conviction, and that’s the secret to long-term outperformance.